Friday, February 29, 2008

Solving the UK Current account deficit

Readers Question I am currently trying to understand the policy options available to the UK Government given the large UK Current Account deficit. Do you have any articles specific to this area that I could read or even if you could reply briefly with your opinion of the policy options available to the government it would really help me in my understanding.

It's an interesting question. The first issue is should the government worry about the UK Current account deficit in the first place?

There was a time when a current deficit of 2% would be seen as a damaging economic problem, it could even become a political issue. But, these days, should we care if we have a current account deficit? (The UK current account deficit is currently close to 5% of GDP - a record figure)Reasons not to worry about Current Account deficit

The argument is that in recent decades, due to globalisation, there has been an improvement in capital flows which make it much easier to finance a current account deficit. It is also worth bearing in mind there are two main ways of financing a current account deficit.

Short term Capital flows - buying UK bonds, securities and other financial derivatives

Long Term Capital flows - Foreign Firms e.g. Japanese firms investing in a new Nissan factory in the North East.

We could make the argument that if we buy Chinese goods, and the Chinese are then happy to use the foreign exchange reserves investing in the UK, what is the problem?

Reasons to Worry About a Current Account Deficit

However, there are reasons to worry about a current account deficit, especially when it starts to reach 5% of GDP. These reasons are:

It does become difficult to attract sufficient capital flows, and when this happens it invariably causes a depreciation in the value of the Pound. (depreciation can lead to inflationary pressures e.t.c)

It means the UK economy becomes reliant on the strength of foreign countries.

It indicates an unbalanced economy. - Relying on consumer spending and weak in the exporting manufacture sector.

There is a lot more to this issue. However, it is worth bearing in mind when we look at the issue of how to reduce a current account deficit. This is because if we are not convinced it is a real problem some solutions will not be worth pursuing, because the costs are greater than the benefits.

Solutions to a Current Account Deficit.

1. Slowdown Consumer Spending.

The best way to reduce imports is to reduce consumer spending and boost the savings ratio. The Government could increase taxes and reduce government spending (deflationary fiscal policy). This will reduce consumer spending. This will be effective in reducing the current account deficit because the UK has a high propensity to import. (about 40% goes on imports)

However, to reduce consumer spending will cause a fall in economic growth and higher unemployment. So it is rather a drastic policy.

The government may not need to reduce consumer spending as the economy is predicted to slowdown in 2008. This slowdown should reduce the current account deficit.

2. Boost Productivity.

In the Long term the government could try and increase the productivity of industry. This will enable UK exports to become more competitive helping to increase exports and reduce the attractiveness of imports. To increase productivity the government can implement supply side policies such as:

Better education and training

Privatisation

Investment in transport / infrastructure

Of course supply side policies are easier to say than do. Every government will say they are trying to increase productivity. But, in reality there is only so much government policy can do to increase productivity of industry. Even successful supply side policies will take a long time to have any effect.

3. Devaluation.

The obvious solution for a current account deficit is to devalue the currency. This makes UK exports cheaper and imports more expensive. This should improve the current account deficit.

However,

How exactly does the government devalue the exchange rate? The exchange rate is determined by market forces not the government. True the government could sell pound reserves, but, this is only a fraction of the market these day. Lower interest rates would weaken the currency. But, interest rates are set by the MPC and their target is inflation not the current account deficit.

Furthermore demand for UK exports has become more inelastic therefore the boost in export value may be quite limited.

Conclusion

To be honest there is not that much the government can do:

Deflating the economy doesn't make sense

Supply side policies are all very well, but they are not really going to make much difference in the short term.

My feeling is that the UK economy has become unbalanced; due to the housing boom and willingness to borrow on credit, the UK has become a nation of consumers and importers. Our savings ratio is low and this is reflected in a current account deficit.

However, a part of the current account deficit (and it is hard to say how much) is not a problem and merely reflects the fact the UK has a comparative advantage in attracting capital flows and is not particularly good at manufacturing any more.

I doubt the government will do anything specific to reduce the current account deficit. But, the slowdown in the economy during 2008 should help reduce the size of the deficit.